The High Cost of Taxing Telecom

The High Cost Of Taxing Telecom

by Jeffrey A. Eisenach, Ph.D.

Jeffrey A. Eisenach is President and co-founder of The Progress & Freedom Foundation.

Introduction and Summary

Driven by technological progress, the telecommunications industry is nearing the end of a 30-year transition from natural monopoly to competitive market. Public policy has recognized this change through substantial deregulation and creation of a legal framework designed to facilitate competition. Tax policy, however, has not kept pace with the changing nature of the telecommunications business. As a result, the telecommunications industry is subjected to a vast array of taxes that have no apparent justification in the modern era and can be explained solely as holdovers from all but forgotten era. Simply put, there are too many taxes on telecommunications services, and they are far too high.

Taxes on telecommunications are, inevitably, taxes on the Internet. Whether through dial-up access or Digital Subscriber Lines (DSL), over cable modems or wireless ones, access to the Internet takes place over the telecommunications network. Thus, high telecommunications taxes slow the spread of Internet access and discourage deployment of the broadband networks needed for the next generation of Internet growth. They raise the costs of electronic commerce for every business, big or small, and raise the price of Internet access for every household, rich or poor. Their impact is probably greatest, however, on poor households, small businesses and rural communities.

The convergence of previously separate telecommunications technologies -- cable, telephone, satellite, wireless -- into a single marketplace adds further urgency to the need for telecommunications tax reform. Each of these different industry sectors is subject to its own tax regime, meaning that the same service can be subject to very different tax treatment depending on the type of firm that offers it, and efforts to eliminate such consistencies are hampered by the extreme complexity of the system.

This paper represents a first step in an effort to reassess and to recommend reforms in telecommunications taxes. It describes the current regime and presents very preliminary findings about the impact of current policies in terms of both economic efficiency and fairness. The paper concludes with a brief discussion of potential policy implications.

Telecommunications Taxes in the United States

Telecommunications services in the United States are subject to an almost incomprehensible array of taxes at the local, state and Federal levels. Indeed, there are so many taxing entities levying so many taxes, fees and other charges that there literally is no comprehensive data source from which a complete listing can be obtained. Nevertheless, it is possible to paint a fairly accurate picture of the overall level of telecommunications taxes.

Federal Taxes: The Federal government taxes telecommunications in three significant ways. First, it levies a three percent excise tax on all telecommunications services. Second, it imposes fees on long-distance carriers which are used to subsidize the provision of telecommunications services, wiring and computer-related equipment at schools, libraries and rural health care centers. Third, it oversees a system of "access charges" through which long-distance phone carriers subsidize the below-cost provision of local telephone service to selected customers. Of these, only the first is universally agreed to be a "tax."

The Federal telecommunications excise tax (FET) adds three percent to the cost of every telecommunications bill. It covers both long distance and local telephone service for both residential and business customers. Revenues from the tax are treated as general revenues. The FET is projected to raise about $5 billion in FY 1999. As shown below, this makes it the third largest general revenue excise tax in the U.S. budget, just behind alcohol and tobacco. Nevertheless, the tax accounts for less than four tenths of one percent of Federal revenue. By comparison, the Office of Management and Budget estimates the FY 1999 Federal budget surplus at $99 billion.

Table One: General Fund Excise Taxes

Product / Revenue
(FY 1998, millions) / Share of On-Budget Federal
Revenue
Alcohol / $7,215 / 0.53%
Tobacco / $5,657 / 0.44%
Telecommunications / $4,910 / 0.38%
Source: Office of Management and Budget

The second major tax on telecommunications services is the tax levied on long distance carriers to support the Federal Communications Commission’s "e-rate" program. In May 1999, the FCC voted to raise the annual amount of this tax by approximately $1 billion to $2.25 billion annually. These taxes are passed through by long distance carriers to individual customers, increasing monthly bills by just over $1 per month per line.

The third major Federal tax levied on telecommunications services is the most ambiguous and controversial of all: It is the system of access charges imposed on long-distance carriers to compensate local carriers for use of the local facilities used to complete long distance calls. While a comprehensive analysis of the access charge system is far outside the scope of this paper, it is generally agreed that the charges are higher than can be justified by the economics of local access per se, and in fact are part of the "universal service" regime that holds prices for some customers below cost by raising prices on other customers. To the extent access charges represent de facto government mandated transfers from some customers to others, it is difficult to argue that they are not "taxes."

State and Local Taxes: While Federal taxes on telecommunications services are both high and complex, state and local taxes are both much larger and far more complex.

As shown in Table Two below, there are approximately 37 different types of taxes levied on telecommunications services by state and local governments in the United States. These include excise taxes, franchise fees, right of way charges, gross receipts taxes, license fees, 911 fees, public utility taxes and even special levies for programs such as poison control centers. In some cases these taxes apply to local telephone services only; in others they extend across state borders and apply to long distance services as well. Wireless services are often taxed differently from landline services, and -- as discussed further below -- telecommunications services offered by non-traditional carriers such as competitive local exchange carriers (CLECS) may in practice be taxed differently from the same services when offered by traditional carriers.

Table Two: State and Local Telecommunications Taxes

State / Local/Municipal
Franchise Taxes / Franchise Taxes
Sales & Use Taxes / Sales/Use Taxes
Telecommunications Excise Taxes / Local 911 Tax
Gross Receipts Taxes / Excise Taxes
License Fees / Telecommunications Taxes
Utility Taxes, Utility User Taxes, PUC Fees / Gross Receipts Taxes
Rental/Lease Taxes / License Fees
Utility Sales Taxes / Utility Taxes
Business & Occupation Taxes / Access Line Tax
Infrastructure Maintenance Fees / Rental/Lease Taxes
911 Fees, Emergency Operation Charges, 911 Database Charges, 911 Equalization Surcharge / Telephone Relay Surcharge/Universal Lifeline Surcharge
Intrastate Surcharge / Public Service Taxes
High Cost Fund Surcharge / Utility Users Tax
Relay Service, Communications Devices Surcharges, Universal Access Charges / Infrastructure Maintenance Fees
Access Line Charges / Right-of-Way Charges
Infrastructure Fund Reimbursement / 911 Fees
Poison Control Surcharge (TX) / Business & Occupation Taxes
Public Utility Commission Fees
Teleconnect Fund
Universal Service Charges, Universal Lifeline Telecommunications Surcharge
Source: AT&T, The Progress & Freedom Foundation

One important data base for analysis of telecommunications taxes is contained in a survey published annually by the Federal Communications Commission. The FCC survey reports on 21 types of actual taxes, fees and other charges appearing on local telephone bills for 95 communities in 41 states.

The FCC data do not include taxes levied on long distance services, nor do they distinguish between taxes levied by state governments and those levied at the local level. However, they do make it possible to determine the overall level of Federal, state and local taxes on local phone bills in both absolute and percentage terms.

Table Three below summarizes this FCC survey data for the 20 highest-tax major metropolitan areas for 1997, the last year for which the Commission has made available the disaggregated data required for our purposes. It shows that taxes on local telephone service amount to as much as 35 percent of the total phone bill, accounting in some jurisdictions for over $4 per month, or as much as nearly $60 per year. For the 95 jurisdictions overall, taxes average just over $2 per month, or about 16 percent of the total local service bill.

The FCC data also permit us to compare the relative magnitude of different types of taxes. As shown in Figure One (on the following page), state and local excise taxes account for over half (52 percent) of the taxes on a local telephone bill. State and local fixed fees add another four percent of the total, while 911 fees (also levied by state and local governments) make up yet another 22 percent. The Federal excise tax accounts for less than one fourth (22 percent) of the taxes on a local phone bill.

Table Three:

Telecommunications Taxes in the

Twenty Highest-Tax Cities

City / Tax
Amount / Rate
1. Richmond, VA / $4.85 / 35.7%
2. Corpus Christi, TX / $2.57 / 27.7%
3. Tampa, FL / $3.06 / 25.9%
4. Chicago, IL / $2.74 / 25.3%
5. Baltimore, MD / $4.15 / 25.1%
6. Dallas, TX / $2.63 / 24.9%
7. St. Louis, MO / $2.57 / 22.7%
8. Kansas City, MO / $2.55 / 22.5%
9. Brownsville, TX / $1.99 / 22.2%
10. Houston, TX / $2.44 / 21.7%
11. Los Angeles, CA / $2.43 / 21.6%
12. San Antonio, TX / $2.10 / 21.0%
13. Fort Worth, TX / $1.93 / 19.2%
14. Oakland, CA / $2.14 / 19.0%
15. Atlanta, GA / $3.31 / 19.0%
16. Salinas, CA / $1.97 / 17.5%
17. San Jose, CA / $1.85 / 16.5%
18. Miami, FL / $1.73 / 16.2%
19. Detroit, MI / $2.15 / 16.2%
20. Huntsville, AL / $2.48 / 15.2%
Weighted Average
(95 Cities) / $2.04 / 15.7%

Because these figures include only taxes that are imposed on local telephone service, they do not reflect the Federal "e-rate" tax (which is imposed on long-distance carriers and passed through to consumers on long-distance bills). Similarly, they do not account for the portion of the Federal excise tax applied to long distance charges, or whatever portion of Federally mandated access charges one might attribute to universal service and thus appropriately characterize as a tax. Even if these charges were included, however, they would not change the basic conclusion that emerges from Figure One: On average, states and localities tax telecommunications even more heavily than does the Federal government.

The FCC data also permit an examination of the trend in telecommunications taxes over time. As shown in Figure Two below, the trend is towards significantly higher taxes. Since 1986, the average tax rate on local phone bills has risen from 10.7 percent to 17.6 percent. In dollar terms, taxes on the average monthly phone bill have risen by 62 percent during this period, from $1.51 in 1986 to $2.41 in 1998.

[ bar chart ]

In summary, telecommunications taxes in the United States are numerous, complex, high relative to other goods and services -- and getting higher.

The High Cost of Taxing Telecom

Economists and other policy analysts agree on three broad criteria by which tax policy should be judged: Efficiency, equity and enforceability. The efficiency criteria implies that taxes should reduce overall economic welfare as little as possible. The equity criteria suggests that taxes should contribute to (or at least not detract from) some generally accepted sense of fairness in the distribution of income and wealth. The enforceability criteria simply means that taxes ought to be designed in a way that minimizes the administrative and other costs of collecting them.

In the pre-competition, pre-Internet world of plain old telephone service, telecommunications taxes probably looked relatively good by these traditional standards of tax analysis:

• Efficiency: Historically, telecommunications taxes probably caused relatively small welfare losses. This is because the quantity of plain old telephone service (POTS) purchased (especially local service) was relatively insensitive to price (it was price inelastic), and thus unresponsive to any price increases caused by high tax rates. So long as taxes did not produce large changes in the quantity or types of telecommunications services purchased, the misallocation of economic resources caused by telecommunications taxes was small.

• Equity: Telecommunications taxes were part and parcel of a system of price regulation that provided significant subsidies for those at the lower end of the income spectrum or who, for whatever reason, were felt to deserve relatively low telephone prices. And, because telecommunications carriers were guaranteed a regulatory rate of return, neither they nor their shareholders suffered when taxes were raised.

• Enforceability: Telecommunications taxes were levied on a single provider, the monopoly telephone company, which was sufficiently large and sophisticated to comply efficiently with even a fairly complex tax regime. To the extent there were ambiguities in the system, these could be worked out between the lawyers for the phone company and the tax collectors, probably in conjunction with the state regulators.

As discussed in the Appendix, however, there are massive changes underway in the telecommunications marketplace. These changes turn the calculus of telecommunications taxes on its head. Whereas telecommunications taxes may once have been relatively desirable (as compared with other taxes), they are now arguably the most destructive taxes being levied on the American economy.

The work now underway at The Progress & Freedom Foundation aims to present a complete analysis of the impact of telecommunications taxes, and the objective of this paper is not to anticipate or prejudge the results of that analysis. At the same time, it is already quite apparent that, in today's converged, digital, Internet-defined marketplace, telecommunications taxes do not hold up well to the scrutiny of the traditional analysis described above.

Telecom Taxes and Economic Efficiency: From the perspective of tax analysis, the most significant change in telecommunications markets may lie in the changing nature of telecommunications demand. Whereas demand for POTS was relatively inelastic, demand for the vast array of new telecommunications products appears to be relatively price elastic. Technically, this means that a relatively small percentage change in the price of telecommunications products results in a relatively large percentage change in the quantity purchased. In practical terms, it means that telecommunications taxes may cause many people to purchase fewer telecommunications services than economic efficiency would require.

Consider, perhaps most importantly, the market for broadband communications -- i.e. for high-speed connections to the Internet. In the past, high-speed Internet access was available only through so-called "T-1" lines which, at $2,000 or more per month, were affordable only by large corporations or the very wealthy. Recently, however, two new technologies have emerged that make broadband access potentially affordable for virtually everyone. Digital Subscriber Line (or "DSL") technology allows a standard telephone line to be converted into a high-speed data line. Offered by the major telephone companies, as well as a growing cadre of competitive "CLECs" and "DLECs," DSL services are being offered in many areas of the country for $40-$60 per month. At the same time, Cable Modem technology is now offering very similar services at competitive prices.

Making affordable broadband services available to all Americans is one of America's highest economic priorities. As FCC Chairman Bill Kennard put it in a recent speech, "despite all the technical advances and globalization, the formula for economic success has remained the same: economic prosperity relies on high-speed access to the critical network of information and commerce. That network is the Internet, and the type of access needed is broadband."

The available evidence suggests that demand for broadband services is highly elastic -- that is, sensitive to price. A recent study by Robert Crandall and Chuck Jackson, for example, estimated that only four million consumers would be willing to pay $70 per month for an upgrade from 56.6 kb/s Internet access to 1.1 Mb/s, but 20 million would pay $25.

Applying the available evidence on elasticities of demand for broadband services to current telecommunications tax rates yields disturbing results. Indeed, as shown in Table Four below, the available evidence suggests telecommunications taxes already are having a significant impact in slowing the adoption of high speed Internet access to American households. And, as the number of households with access to broadband services grows, this effect will grow in the future. Specifically, at the national average telecom tax rate of 16 percent, we estimate that at least 165,000 households, and perhaps as many as 2.9 million households, are being effectively priced out of the market for broadband Internet access in 1999. As the availability of broadband services spreads, and the number of potential customers grows, these estimates go up significantly over time. By 2002, at current tax rates, we estimate that between 1.2 million and 4.2 million households will be denied broadband Internet access by high telecommunications taxes.

If telecommunications taxes were to continue to rise, the impact would grow more than proportionately. For example, a 20 percent tax burden (similar to current rates in Baltimore, Dallas, Los Angeles and Tampa) is estimated to reduce broadband penetration by approximately 11 percent. However, a 33 percent burden (similar to the current rate in Richmond, Virginia) reduces predicted broadband penetration by nearly 20 percent.

Table Four:

The Impact of Telecommunications Taxes

on Broadband Penetration

Tax Rate / Impact on Penetration (Percent) / Households Denied Internet Access / Children in Households Denied Internet Access
1999
16 % / -7.5 % / 0.2 million - 2.9 million / 0.1 million - 1.9 million
20 % / -9.3 % / 0.2 million - 3.6 million / 0.1 million - 2.3 million
33 % / -18.9 % / 0.4 million - 7.3 million / 0.3 million - 4.8 million
2002
16 % / -7.5 % / 1.2 million - 4.2 million / 0.8 million - 2.7 million
20 % / -9.3 % / 1.5 million - 5.2 million / 1.0 million - 3.4 million
33 % / -18.9 % / 3.0 million - 10.6 million / 1.9 million - 6.9 million
Source: The Progress & Freedom Foundation

Telecom Taxes and Equity: The equity consequences of telecommunications taxes are also being affected by the changing marketplace. As noted above, telecommunications taxes in the pre-competition, pre-digital environment were part and parcel of a regulatory regime that set virtually all prices at levels designed to ensure equity while offering a fair return to telephone companies. Thus, prices could be set in such as way as to offset the inherently regressive nature of fixed and excise (i.e. percentage) taxes on telecommunications.